Be optimistic about Mexico, but also be smart

PeterKohli

Having covered promising investments in South America (Brazil, Chile, Colombia and Peru, we’re moving north this week, taking a look at Mexico, followed by others in Central America.

Anyone familiar with my investing philosophy knows I focus on developing markets. Admittedly, in many aspects, Mexico is a different animal, in part because its economy is already so entwined with that of North America. In fact, you could inadvertently gain significant exposure to Mexico just by investing in large-cap North American-based companies. Coca ColaKO, -0.26%
for instance, has said it will continue to invest at least $1 billion/year in Mexico through 2020. Mexico is Coke's largest market outside the United States, and it co-owns bottler Coca Cola FEMSAKOF, -0.70%
Many other marquee US companies follow this pattern.

If you've read the papers over the last 20 years, you're aware of the sheer volume of formerly U.S.-based manufacturing jobs that have moved to Mexico. Overall, its manufacturing cost is approximately 25% lower than that of the U.S. It's no surprise then that up to 80% of the country's exports are in manufacturing.

Mexico offers an attractive business climate, legal certainty, one of the largest free-trade agreement networks in the world and highly developed industry groups. Furthermore, it is the second-largest economy in all of Latin America. By 2050, Mexico could have the fifth-largest economy in the world, above the U.K., according to Goldman Sachs.

Its macroeconomic financials are sound, with international reserves of $163 billion (almost three times its foreign debt). The average growth of the Mexican economy for the 2013-2019 period is 4%, with a controlled inflation rate of 3.8%.

Ironically, almost everyone is optimistic about Mexico, except for Mexicans. Earlier this year, Moody's raised Mexico's bond rating a full notch, confirming the confidence investors have in the structural reforms of the Mexican government and growth of its economy. That same day in February, Mexico's national statistics service released a survey showing consumer confidence has sunk to its lowest level since the world economic crisis in 2009.

The citizens' pessimism is rooted in worries over rising prices, new taxes and stagnant wages, among other concerns. This means that even though Mexico's middle class is continuing to expand and thrive in some regions, I wouldn't make the usual jump to concluding they will spend the majority of their new found money on consumer goods.

To put it in perspective, the growth of the Mexican middle class is miniscule compared with what is going on in China, where the middle class grew sixfold over the past 10 years. Mexico's middle class increased 11.4% over the same period, according to an INEGI study — large enough to discourage some illegal immigration to the U.S., but the people remain wary. The middle class represents about 39.2% (44 million) of the country's total population. However, if you look at the top and the bottom of the spectrum, there is one elite upper-class citizen (1.7% or 1.34 million people) for every 49 in the lower class (59.1% or 66.4 million residents).

As long as Mexico's citizens remain pessimistic, and the class spectrum so widely unbalanced, I wouldn't bet on more than a slight uptick in retail sales of consumer goods outside of certain subsectors, such as flat-screen TVs and cellular phones.

What I do think shows promise, however, is the financial sector. The Mexican banking system is profitable, liquid and well-capitalized.

Investors can take advantage of the financial services sector with the ADR for Santander MexicoBSMX, +0.71%

Another promising sector is infrastructure. Mexico's government expects public and private infrastructure spending to reach nearly $600 billion over the next five years. This compares very favorably with some other developing countries. India, for example, has said it will spend less than a tenth of this amount over the same period.

The major Mexican ETFs are not focused on high concentrations of either or both financial and infrastructure companies. They provide more of a broad exposure to the Mexican market. These include iShares MSCI Mexico Capped ETFEWW, -0.32%
which contains about 18% of financial services firms. There are also major sector ETFs that include Mexico among other regions, such as iShares Emerging Market Infrastructure UCITS ETFEMIF, +0.24%
(with Mexico concentration of just 8%).

Beyond these, Mexico is distinct in that its mining output has reached levels never seen before. In 2012, it was the largest producer of silver in the world, at about 19% of global production. Gold and copper are produced in volumes of 2.7% and 2% of world production, respectively.

That said, I am not as positive on mining, the country's fourth largest industry (5% of GDP), as you might expect since in late 2013 the government enacted its first levy — a royalty of up to 7.5% on profits, plus 0.5% on revenues from precious metals. Previously, Mexico had only charged miners income tax of 30%. The moves put it in line with regional competitors like Brazil and Peru.

It's easy to see why the government has gone after such identifiable revenues in a country where tax avoidance is the norm. Mining was not the only sector targeted. Manufacturing exporters lost some tax privileges and value-added taxes were put on things like soft drinks and pet food.

As a result, I wouldn't make particularly narrow bets on Mexican mining.Rather I'd make broader regional best via a vehicle such as Global X Silver MinersSIL, -1.62%

Mexico, for all its strengths, is still an economy in transition and your investments should take that into consideration.

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